By Keith Gangl, CFA
There are four phases in a business cycle that describe different stages of economic activity, ranging from expansion to contraction. Economists and investors are often trying to anticipate transitions in these phases as the rotation from growth to contraction (and vice versa) can have a significant impact on what segments and sectors are more attractive for investment.
There are four different stages of economic activity, and they follow a wavelike pattern, which can be seen the graph below. The four stages include:
- Expansion – GDP is growing and company profits are strong.
- Peak – Economy starts to overheat as we near the high point of the cycle.
- Contraction – Both GDP growth and corporate earnings are in decline.
- Trough – Sharp decline in economic activity which represents the low point of the cycle.
Business cycles and the various phases within have no defined length of time and can last from months to years, which makes it difficult to predict when and if the contraction phase turns into a recession. There can also be mini fluctuations between expansion and contraction before a full business cycle is complete.
Midway through last year, many strategists and investors believed that the US economy was in the later innings of the contraction phase and a recession was just around the corner. Contributing to the thesis a recession was near was the high rate of inflation, measured by consumer price index (CPI) which peaked at 9.1%2 in June of 2022, along with a Federal Reserve that was aggressively raising interest rates to reduce inflation which also slows the growth of the economy.
As decreased spending power and higher interest rates proliferated the economy, the probability for a contraction or recession was increasing. As we have witnessed in 2023, those forecasts have yet to materialize as reported second quarter GDP growth rate accelerated to 2.4%1 from the first quarter rate of 2.0%, seen in the chart below.
Also, two of the larger headwinds of economic activity have been inflation and interest rates. Core inflation remains elevated, but levels are receding. This has spurred the Federal Reserve to more frequently discuss pausing continued interest rate increases. As a result, investors are reassessing where the economy is in the business cycle and when the next recession will materialize.
Understanding the different phases of the business cycle can help investors allocate to investments that historically do well in the various parts of the cycle. The US economy will never be able to fully avoid recessions in the future as contraction is a natural and inevitable part of the business cycle. At Gradient Investments, we believe in a diversified approach and staying invested, and it is even more critical as we navigate these uncertain times and the various phases of the business cycle. Currently, our belief is the US economy is resilient and a recession is farther out on the horizon than consensus expectations, but we will continue to monitor changes in the business cycle and invest accordingly.